Does liquidity requirement include inflation?

[Gersonides]

Suppose you manage a foundation and your annual spend rate is 5%, mgmt fees are 0.5%, and inflation is 2%. What would your liquidity need be for next year?

 

[MrSmart]

Inflation is a long term objective
Take this. Assets are 100, real spending 5%, inflation 2%.
Would you need 5 for this year, or 7?
Let’s do maths.
5*1.02 = 5.1
Hmm, if inflation applies to this year, then that doesn’t change much from my real spending expectations….I won’t be needing 7 for sure.
But if you only make 5% per year, and your 5.1 keeps growing 2% every year, in addition to the 5% real return (assuming the 5% policy is fixed, not a constant growth expense), you’ll run out of assets in around………31 years.
To keep that from not happening, you need to earn exactly 7%, where real spending and inflation, stop pressuring you to earn more than that. And current policy spending is ALWAYS 5% of your assets in any given year.

 

[Gersonides]

How would you concisely phrase the liquidity constraint in an IPS (in the context of an AM exam question?)

 

[Mipato]

Depends
In your specific scenario, your liquidity req will be a 5.5% allocation to cash equivalent. It doesn’t matter if inflation is 1% or a million%, you are still paying out the same % of your total assets per annum. Inflation only is relevant in making sure that 5.5% of assets next year can buy as much as 5.5% of assets this year.
But if you have something like an individual IPS question where you have a net income need that rises with inflation, and you are given a specific year to calculate liquidity need for along with a statement like “client wants to keep enough cash on hand to cover a year’s worth of expenses”, then it would be perfectly fair for them to expect you to connect the dots and say that a 100k expense need last year will be 102k this year. Or for a more one-off cash flow like University tuition, if you know this will rise by 5% a year and it was 10k last year, you’ll want to set aside 10.5k next year.

 

[cokemicho]

Gersonides wrote:
How would you concisely phrase the liquidity constraint in an IPS (in the context of an AM exam question?)

You detail the different items you are considering as liquidity issues, you put the sum and thats it.